Question

RETURN ON INVESTMENT AND ECONOMIC VALUE ADDED OBJECTIVE CALCULATIONS WITH VARYING ASSUMPTIONS

Knitpix Products is a division of Parker Textiles Inc. During the coming year, it expects to earn income Of $310,000 based on sales of $3.45 million; without any new investments, the division will have average operating assets of $3 million. The division is considering a capital investment project—adding knitting machines to produce gaiters— that requires an additional investment of $600,000 and increases net income by $57,500 (sales would increase by $575,000). If made, the investment would increase beginning operating assets by $600,000 and ending operating assets by $400,000.

Assume that the actual cost of capital for the company is 7 percent.

Required:

1.    Compute the ROl for the division without the investment.

2.    Compute the margin and turnover ratios without the investment. Show that the product of the margin and turnover ratios equals the ROI computed in Requirement 1.

3.    Compute the ROI for the division with the new investment. Do you think the divisional manager will approve the investment?

4.    Compute the margin and turnover ratios for the division with the new investment. Compare these with the old ratios.

5.    Compute the EVA of the division with and without the investment. Should the manager decide to make the knitting machine investment?

Answer 1

1. ROI for the division without the investment = Net Income / Average Operating Assets = $ 310,000 / $ 3,000,000 * 100= 10.33 %

2. Margin = Net Income / Sales = $ 310,000 / $ 3,450,000 = 0.08986 or 8.986 %

Turnover = Sales / Average Operating Assets = $ 3,450,000 / $ 3,000,000 = 1.15 times.

ROI = 8.986 % x 1.15 times = 10.33 %.

3. ROI for the division with the new investment = $ ( 310,000 + 57,500) / $ ( 3,000,000 + 500,000) = $ 367,500 / $ 3,500,000 = 0.105 or 10.5%

Divisional manager should approve of the new investment, as the ROI of 10.5 % post the new investment is higher than the current ROI of 10.33%.

4. Margin after the new investment = Net Income / Sales = $ 367,500 / $ ( 3,450,000 + 575,000) = $ 367,500 / $ 4,025,000 = 9.13 % ( Higher than current margin)

Turnover after the new investment = Sales / Average Operating Assets = $ 4,025,000 / $ 3,500,000 = 1.15 times ( same as current turnover)

ROI = 9.13% x 1.15 = 10.5%

5. EVA before the new investment = Net Income - ( Average Operating Assets x Cost of Capital) = $ 310,000 - $ ( 3,000,000 x 7%) = $ 100,000.

EVA after the new investment = $ 367,500 - $ ( 3,500,000 x 7%) = $ 122,500.

Yes, based on the EVA before and after the investment, the manager of the division should decide in favor of the knitting machine investment.